Choosing an asset allocation, or the mix of stocks, bonds and cash in your portfolio, is probably the most important investment decision that you’ll make. A study by Ibbotson Associates concluded that asset allocation decisions determine about 100 percent of investment performance for those who follow a low-cost, long-term investing strategy. Similarly, when investors underperform the market, the primary culprit is a failure to maintain one’s allocation during tough times. A study by Dalbar and Associates showed that from 1989 to 2009, investors underperformed market benchmarks by a whopping 6.5% annually, primarily because they shifted their asset allocation out of equities following a period of low returns. Investors who take the time to thoroughly evaluate their financial and emotional tolerance for risk will be much more likely to stick with their asset allocation plan when the going gets tough, thus maximizing their investment returns. Let’s take a look at the two main components of one’s investing risk profile.

Risk Capacity

Risk capacity is the degree of portfolio volatility that you can tolerate based on factors like time horizon (until retirement), cash needs, income and the size of your investment accounts. Since it’s based on objective criteria, this dimension of risk is fairly easy to quantify using a questionnaire. The largest determinant of risk capacity is time horizon. Early in life, when retirement is far off, your future earning potential can be thought of as a sizable bond, allowing you to allocate the majority of your retirement portfolio to more volatile equity investments. As you grow older and your future earning potential decreases, it’s important to replace those bond-like expected earnings with a higher percentage of bonds in your portfolio. By the time you retire, most of your investments should be in bonds and cash in order to provide a reliable, low-volatility source of income.

Risk Attitude

Risk attitude is the degree of portfolio volatility that you can tolerate on an emotional level. It is more difficult to quantify than risk capacity. As we learned in the Dalbar study mentioned above, many investors make the mistake of failing to understand their risk attitude until a market downturn occurs. This usually leads to selling equity investments at the worst time (the bottom of the market), only to miss out on a subsequent market rebound. This is a difficult trap to avoid, especially for inexperienced investors. Some are able to better gauge their risk attitude by studying charts of past portfolio performance. For example, take a look at the historical growth of $10,000 with two portfolios, a 70/30 equity/bond allocation and a 60/40 split. Would either portfolio allow you to sleep at night during the major market downturns (2000-2002, 2008)? If not, dial back the volatility by adding more bonds.

Conclusion

Your overall risk profile consists of the two main dimensions discussed above. In general, your most conservative risk dimension should limit your portfolio’s equity/bond split. For example, if you have the financial capacity to handle a portfolio of 80% equities, but can only stomach the volatility of a 70% equity portfolio, you should choose the more conservative allocation. Remember that developing a plan that you can stick with in good times and bad is much more important than maximizing your expected return. Once you’ve taken the time to understand your risk profile and arrive at an appropriate mix of equities and bonds, you’re ready to move on to the next step of the asset allocation process: breaking down the equity and bond portions of your portfolio.

Reminder: If you need help quantifying your risk profile, we can help. Every portfolio recommendation on Invest-it-Yourself.com comes with a breakdown of your risk profile, as determined by your answers to our risk questionnaire. Get your free portfolio recommendation today!